Book Review : Too Good To Be True By Erin Arvedlund

“What do you mean he’s been arrested?” she screamed. “But that’s where all our money is!” – Ellen Jaffe, wife of Madoff agent Robert Jaffe.

The central theme of the Bernard Madoff affair is that you can only trust yourself with your money. You cannot rely on personal relationships, cultural ties, regulation, due diligence, the historical relationship of your family with the asset manager or any other reason. You simply must conduct ongoing due diligence of every asset class you are exposed to and the “professionals” that you deal with.

A track record of solid performance doesn’t mean that your investments are safe or even being managed properly. There is always a risk of fraud or misappropriation if the correct procedures aren’t being followed with your money. Arvedlund describes in detail how all of the investments in Mr Madoff’s fund went to one JP Morgan Chase checking account. Billions of dollars flowed in and out, with nothing ever being done about it.

The fraud also played on Jewish ties – country clubs with predominantly Jewish members, Jewish social circles, Jewish foundations and university endowments. Working class Jews were also targeted through lower level agents and referrals from Madoff employees themselves. Holocaust survivors like Elie Wiesel lost money. Absolutely sociopathic abuse of cultural ties on the part of Madoff.

“Recessions catch what the auditors miss” – John Kenneth Galbraith

In 2008 the global financial crisis begun. Because of Madoff’s reputation for quickly returning customer money, he was flooded with almost $7 billion in redemptions towards the end of 2008. He didn’t have enough cash on hand and couldn’t raise any more money from the feeder funds who raised money for him.

Through telling his sons and pleading guilty, he avoided a trial. He also avoided a lot of the arcane but interesting details being brought to light. Arvedlund expounds on the network of feeder funds and how they worked. In exchange for a management fee and performance fee, these funds trawled the charity ball circuit and wealthy social circles for new investors. They then wired their money to Bernard Madoff. The people who earned commissions from Madoff lived lavish lives of luxury and didn’t ask too many questions – they simply couldn’t go back to the way they lived before the Madoff kickbacks.

Investors received regular but not excessive returns. It is clear that some investors had “returns to order” produced where they could invent losses in their Madoff accounts to offset their tax bills. When people asked questions Madoff always had an answer at hand. When Madoff investors were confronted by other people in the financial industry about the impossibility of Madoff’s consistent returns they ignored the suggestion that they remove money from their Madoff investments. It simply was “too good to be true”.

There is a sort of schadenfreude about the Madoff affair. The trustee Irving Picard is analogous to Breeden in the Conrad Black case. He is making millions of dollars managing the recovery of assets for investors. Some investors stand to receive more back than they initially invested in Madoff because their other investments have performed dismally during the global financial crisis. Ignoring opportunity costs and taxes paid on fictitious returns, it is estimated that at least half of Madoff’s investors will lose no capital.

Bernard Madoff played on our need to feel special, like we are one of the elite. By making it hard to invest in his fund he created an air of exclusivity that made otherwise sophisticated investors act like teenagers not invited to a house party. The need to perform extreme levels of due diligence before investing in anything is another central theme running through the book.

We will never know the true story of the Bernard Madoff affair. We will never know with certainty that all of the assets have been recovered and investors made whole. But some extremely arrogant people had their wings clipped by the collapse of Madoff. This is a good thing in the long-run and why arguments about taxing inherited wealth don’t make sense.

If investors in Madoff had stuck to the rules and not thought that they were better than the great unwashed with their special investment relationship with “Bernie” they wouldn’t have needed to sell their apartments and Palm Beach winter homes. They could have kept their NetJets fractional shares and American Express bills in the six figures.

The investors I feel slightly sorry for are the usual dupes – the “mum and dad” types who invested on the recommendation of friends and family. They never win in the financial markets because they are like people going to the sales without being able to tell a horses rear from its ears. As I’ve written before, they shouldn’t try and invest at all because it always ends in tears.

Relying purely on regulators as a risk reduction strategy as a success rate approaching 0% as evidenced by:

finance companies and the Securities Commission

the NZX, auditors and the Feltex IPO

Bernard Madoff and the SEC

Ratings agencies and mortgage backed securities being rated AAA

The book doesn’t touch on the reality that any investment fund can experience a run at any point in time. If all the investors want to withdraw their money, the fund won’t necessarily have liquid assets to cover the redemptions. It’s like a run on a bank, only investment fund’s will quickly sell off their assets to meet redemption requests. This will depress the value of the investor’s accounts even further.

I have followed the Bernard Madoff story closely. So far, billions of dollars has been recovered and due to the “net winners and net losers” calculation, many investors will actually get all of their money back. For sure, this is without interest and with considerable stress. But I’d wager it’s a better return than they would have got investing in some other asset classes since 2008.

If you like reading about the human side of how these schemes work, I’d definitely recommend checking this book out. It’s yet another cautionary tale about taking everything you read or hear with a grain of salt and pursuing a skeptical line of inquiry into the reality of the situation.